Inflation & interest rates

In previous columns, I explained that the process of inflating the money supply distorts prices. The result is economic decisions made with poor information. Resources are misallocated.

One particular set of prices, however, is especially important when discussing inflation: interest rates. These are prices, for borrowed resources, that coordinate economic activity over time.

Suppose we choose to save more. This change in our preferences means we're willing to consume fewer things today in exchange for more things tomorrow. From each of our perspectives, this saving involves actions such as putting more money into savings accounts or buying more shares of corporate stock. From the economy's perspective, additional saving releases some resources from the need to produce goods for consumption today. These resources become available to be used to produce more capital goods such as factories, machines and worker training.

An increase in saving reduces real interest rates. These lower rates "tell" investors to produce fewer consumption goods and more capital goods. Of course, each investor sees only the lower price of borrowing. But this lower price means that some investments that previously were unprofitable now are profitable. Profit-seeking investors rush resources into these now-worthwhile projects.

Here we see the potential problem with the Federal Reserve's control of the money supply. Because saving, lending and borrowing are done in dollars, when the Fed pumps out too many dollars, it appears to banks as if saving has risen. Banks have more funds on hand. Competing for business, banks then lower interest rates, prompting investors to borrow more in order to produce more capital goods.

But increasing the money supply doesn't really increase people's willingness to save. Lower interest rates caused by money-supply growth are an economic lie. They trick investors into thinking that people are now willing to save more than before. The genuine interest rate -- the one matching people's willingness to save with investors' willingness to invest -- hasn't fallen.

After the Fed's initial wave of new money works its way through the economy, banks find people in fact are still saving at the same lower rate as before the Fed injected the new money. Banks then raise interest rates back to levels that accurately reflect people's willingness to save.

The Fed's economic lie has genuinely sour consequences. If an investor builds a new factory, he expects to be able to acquire the materials and labor he'll need over the course of years, not only to finish building the factory but to operate it profitably. But because he was lured to build this factory only by "fake" low interest rates, once rates are restored to their truthful, higher levels, the factory owner finds he cannot operate profitably at the now-higher cost of borrowing. (Remember, the factory was thought to be profitable only because the Fed lowered interest rates artificially.) As soon as the owner realizes this fact, he cuts his losses by liquidating part or all of his interest in this project. Workers lose jobs.

The Fed -- although thankfully not under the direct control of Congress or the president -- is a government institution influenced by political considerations. If such job losses are widespread, the Fed might succumb to pressure to "solve" the problem by injecting even more money into the economy, thus keeping interest rates artificially low for a longer time. This tactical lie might mislead investors for a bit longer. But the Fed can't lie forever.

Investors eventually catch on to the fact that the amount of resources that people want to save is less than the amount required to sustain current levels of investment. At this point, continued injections of money by the Fed lead only to inflation without sparking even a temporary economic boom. Recall the 1970s' stagflation.

So what's to be done• My favorite proposal is to abolish central banks and allow private banks to issue circulating money.

When people today hear this proposal, their first reaction is disbelief. "That can't work!" they assert. But history says differently. As Lawrence White, George Selgin and other scholars have shown, "free banking" -- which is what competitive note issue is called -- has been tried several times throughout history, typically with much success.

Banks' desire to win customers keeps them from over-issuing their currencies. No one wants to hold, or to accept in payment, currencies whose value is less secure than other available currencies. This same desire propels banks to find ways to reduce their customers' costs of deciphering prices expressed in different currencies.

Such competition is the best way to ensure that prices -- including interest rates -- reveal as accurately as possible people's demands, supplies and preferences for future consumption over current consumption. Economic decisions will be even better with money supplied competitively rather than politically.

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